Monday, 22 May 2017

A Comparison of Shipping Trusts' Business Models

You might be wondering why I am still writing about shipping trusts' business models when there is only 1 shipping trust left. This is because for investors in First Ship Lease Trust (FSL), it is useful to understand the differences between the business models of FSL and Rickmers Maritime to assess whether FSL would go the way of Rickmers Maritime and be wounded up. 

On the surface, both FSL and Rickmers are shipping trusts, however, their business models (at least in the initial stages) are quite different. As an analogy, supposed you wish to become a Uber driver but do not own a car. There are 2 ways to obtain a car, either rent a car from a car rental company, or buy a car by taking out a loan from a finance company. From this perspective, a car rental company is very different from a finance company. Rickmers is in the rental business, whereas FSL started off as a finance business (however, over time, FSL became more and more like a rental business for reasons discussed later).

The business model and risks between a car rental and a finance company are very different. A car rental company would want rental of its vehicles (return on capital) for as long as possible, while a finance company would want return of its loan (return of capital) as quickly as possible. Supposed a car has an economic lifespan of 10 years, a car rental company would hope to rent out the car for the full 10 years, whereas a finance company would hope to recover all its loan by no later than the 7th year.

Going back to FSL and Rickmers, both of them bought 4,250 TEU Panamax container ships in 2008 and leased them out. The structure of the deals shows the differences between a rental and a finance business. FSL assumed the ships have economic lifespan of 25 years and leased them out on a bare boat charter for 12 years. At the end of 12 years, the lessee has an option to buy out the ships. Rickmers assumed the ships have economic lifespan of 30 years and leased them out on a time charter for 10 years. Assuming that the bare boat charter equivalent (BBCE) revenue of a time charter is 65% of the time charter revenue, the cashflows for both shipping trusts work out as follows.

FSL Rickmers
Purchase Price  $70.0M  $72.0M
Daily Charter Rate (Time Charter) NA  $26,850 
Daily Charter Rate (BBCE)  $18,315   $17,453 
Annual BBCE Revenue  $6.68M  $6.37M
Charter Duration (Years) 12 10
Buyout Option Price  $30.0M NA
IRR @ End of Charter 2.16% -2.17%
IRR @ End of Charter with Buyout 6.20% NA

From the table above, the annual BBCE revenue generated by Rickmers in a rental transaction is less than that by FSL in a financing transaction. This is because a financing lessee has to make principal repayments whereas a rental lessee does not. Thus, at the end of their respective charter periods, FSL would be able to recover all its capital and generate a positive annualised return of 2.16% without considering the buyout option. If the lessee chooses to exercise the buyout option, the annualised return would increase to 6.20%. On the other hand, Rickmers would not have recovered all its capital at the end of the 10-year charter period. It would only do so in Year 12. This is not to say that Rickmers' rental model is entirely bad. If it could find shipping companies to rent its ships for the entire 30-year economic lifespan, its annualised return would be 7.96%, much higher than FSL's 6.20%. Unfortunately, in a market downturn where there is little demand for ships, a ship finance business like FSL would be able to recover its capital faster than a ship rental business like Rickmers.

As you can see, the return for FSL is higher if the lessee exercises the buyout option. In fact, the buyout option is probably designed to entice the lessee to exercise it. Based on the purchase price of $70.0M and straight-line depreciation of 25 years, the annual depreciation charge would be $2.8M. At the end of the 12-year charter period, the accumulative depreciation would be $33.6M, leaving the ship with a book value of $36.4M. Assuming that the market value approximates the book value had there been no market downturn, the buyout option price of $30.0M would represent a discount of $6.4M to the lessee. It is actually in FSL's favour if the lessee takes up this option, as it would get back another $30.0M by Year 12, which could be used to initiate a new financing transaction.

From the above example, it also shows that the risks of a rental business and a finance business are different. The main risks of a rental business are market risks, i.e whether it can find shipping companies to rent its ships at good rates. On the other hand, the main risks of a finance business are credit risks, i.e. whether the lessee has the ability and willingness to make principal and interest payments on the loan as scheduled. Going back to FSL, the 3 Panamax container ships that FSL has are leased to Yang Ming Marine Transport Corp. They generate an annual BBCE revenue of $20.0M even though the annual BBCE revenue at current market rates is estimated to be only about $1.6M, assuming 50% utilisation rate (see Sustainability of First Ship Lease Trust's Cashflows for the estimate). If Yang Ming were to default or fail, those lucrative charters would be lost and the viability of FSL would be in question. Thus, FSL's main risks are the credit risks of its lessees.

There is still one more difference between FSL's and Rickmers' business models. FSL's preference is for bare boat charters while Rickmers specialises in time charters. In a bare boat charter, the lessee has to bear vessel maintenance costs, whereas in a time charter, the lessor has to bear these costs. Like a car financing transaction, the lessee (or car "owner") has to pay repair cost or mandatory vehicle inspection cost for the car. The finance company is not responsible for these costs. Whereas in a car rental transaction, the lessee can ask the rental company for a replacement car or deduct rental charges for the period the car is not available for use. In times of market downturn, every cent counts, and FSL's bare boat charters reduce the operating costs needed to run the business compared to time charters.

Having said the above, I mentioned that FSL started off as a ship finance business but gradually became more of a ship rental business like Rickmers. As mentioned earlier, the key risks that a finance business faces are credit risks of its lessees. If the lessee were to default, the ships would be returned to the trust and the trust would have to find new charterers at charter rates that are likely to be lower than the previous charter rates. That is when a finance business becomes like a rental business and faces the same risks. FSL had encountered lessees defaulting previously. In addition, many of its existing charters will be expiring in the next few years. Given the current low market price of ships, none of its lessees are likely to exercise the buyout options. As the charters expire, FSL would progressively become a ship rental business.

Since we are at this topic of shipping trusts' business models, there used to be another shipping trust called Pacific Shipping Trust, which was delisted from SGX in 2012. At inception, its business model was also different from that of FSL or Rickmers. It was set up by Pacific International Lines to monetise its fleet of container ships. Going by the earlier analogy of the Uber driver, this would be a case in which the Uber driver owns a car, but decides to do a sale-and-leaseback. It too became more of a rental business after it expanded its business to lease ships to other companies besides its parent company.

It is probably a moot point now that FSL is progressively becoming a ship rental business, but starting off with the ship finance business model during its initial stages helps to manage the downturn in the shipping industry.

P.S. I am vested in FSL. Also, I will be overseas next week and will not be able to respond to your comments until I return.

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